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Venture Capital Carried Interest Tax Debate – A VC’s Perspective

HB 4213.  Much has been made of late of the Venture Capital Carried Interest Tax Hike Bill.  It carries the gallows-humor title of the “American Jobs and Closing Tax Loopholes Act of 2010.”

Charlie Rangel, the Congressman from Harlem (seen here relaxing on one of his properties which triggered his current ethics investigation) is the bill’s sponsor in the House.

I responded to a post just now by Jose Ferreira, CEO of Knewton, who worked with us several years ago.  Jose is a very smart guy.  His post is here: http://www.huffingtonpost.com/jose-ferreira/in-favor-of-tax-breaks-fo_b_614151.html

A simple idea:  If you tax something more, in the end you will tend to get less of it.  If you tax something less, in the end you will get more of it.  No one disagrees that Venture Capital is good for the American economy.  According to the NVCA, 20% of ALL JOBS in America are in companies that are, or once were, venture backed.  This is really an amazing statistic. Couple that with Thomas Friedman’s statistic that Jose points out – all net jobs created in the last 30 years were by startups – and we definitely want more startups, more venture capital, and more venture capitalists in America.

Now, that does not mean that Venture Capitalists should be entitled to a tax break.  But they certainly should not be penalized.

Government Policy is used to encourage and to discourage activities.  Right now, there is a big focus on creating jobs.  Venture Capitalists create jobs.  Entrepreneurs create jobs.  We should encourage both.  But Congress has other ideas.

Think for a minute about entrepreneurs.  They put in their blood, sweat and tears to start a company.  Most start their business with none of their own money.  But they invest their time.  In exchange they own stock in their company.  On average today, it takes 5-7 years for a successful small technology company to be acquired, or to go public.  During that time the entrepreneur receives a salary.  The entrepreneur pays ordinary income tax on that salary every year.  Once he or she sells the company (5-7 years later) that entrepreneur receives capital gains treatment on that sale.

Now think for a minute about the venture capitalist. Venture Capitalists raise a fund from institutional investors so that they can provide the equity capital for start-up companies to grow. A venture capitalist is paid a salary to manage the VC fund. They pay ordinary income tax on this salary every year, just like the entrepreneur. Once an early stage VC invests in a company, they, too, invest their time working with the entrepreneur for 5-7 years. When the company is sold, their stock (through their carried interest) should be taxed the same as the entrepreneur.

Venture Capital is the riskiest capital in any capital structure.  For early stage venture capitalists, half of all companies they fund do not succeed, and the VCs lose everything they have invested in them when they fail.

Rewarding entrepreneurs and investors who invest their time into building a company over 5-7 years is good policy.  It should be encouraged.  The current tax code does that through the lower long-term capital gains tax rate.  Lets not mess with it!

Dan Primack (http://www.pehub.com/author_column.php?id=229) covers the venture capital industry for Thomson Reuters and disagrees with my position.  He has written often and eloquently on the reasons for his disagreement.  Fundamentally, he believes that taxing carried interest at a capital gains rate is a loophole, and that while VCs bitch and moan about it, none of them will quit because of higher taxes.

I agree with Dan that many current VCs will not stand up and quit immediately if this bill passes.  However, I suggest that those who believe that this bill will not impact the VC industry are forgetting about the law of unintended consequences.

The biggest unintended consequence will be fewer NEW VCs and fewer young VCs and lower total compensation for the newer and younger VCs.  Why?  Two reasons.

First, the VC industry is shrinking and consolidating.  Several hundred funds have closed shop in the last decade.  And most of the larger VC funds (more than $500M under management for a fund) are raising smaller sized funds these days.  With a smaller fund there are less “economics” to split amongst the team.  Less management fee.  And less carried interest.  Which is why the number of venture capitalists working in our industry is actually shrinking today.

Second, like any business person, current venture capitalists don’t want to see their after tax compensation decrease.  Ordinary Federal Income tax rates are going from 36% to 39.6% at the end of the year most likely.  Tack on to that the new .9% increase X 2 (since employer matches) for Medicare Part A for “rich” people (and assume that VCs will also be disproportionately hit by the brand new 3.8% tax on dividends, interest, capital gains).  Then add in the carried interest tax increase from 15% to 35% (current blended proposal) and a VCs take home pay (assuming annual carry equals annual management fee) will drop, after tax, by 18%.  Most of this drop is in the after tax value of the carried interest.  In order to breakeven after tax, that sample VC will have to take 6% more management fee in salary, and will have to increase their share of the carried interest by 33%!!  This means less for everyone else if the senior partners follow this strategy.

What do you think will happen?  Senior VC partners will accept an almost 20% after tax pay cut, smile, and make no changes in their business?

Or will they try to keep their after tax pay the same, and cut their staffs, or pay them less?  Unfortunately I am guessing that this bill will result in more junior VCs seeking new careers.

This is EXACTLY what is happening in small businesses across the country – and why we are seeing anemic job growth.  When the government imposes new costs (health care) and raises taxes (expiring Bush tax cuts + Medicare surcharge + unearned income 3.8% tax) on small business owners, those owners react by cutting back the costs to run their businesses so that 100% of these impacts do not fall directly on their shoulders.  When Government takes more, it is not the small business-man or woman who is hurt most.  It is their employees who suffer with slow hiring and reduced compensation packages.